Swing into cyclicals should resume

The first quarter US earnings season is shaping up to be even stronger than anticipated. With results in from three quarters of the S&P 500 market capitalization, 85% of companies have beaten earnings expectations. In aggregate, companies are beating earnings by 25%, with an outsize contribution from financials. Even excluding financials, the aggregate beat of 19% is impressive, considering that the average earnings beat over the last few years has been about 5%.

As a result, earnings are on pace to climb nearly 45% in the first quarter, higher than our original estimate of 30%. This will put S&P 500 profits at a new quarterly high. In addition, forward estimates are rising and it appears that our full year estimate for 31% EPS growth could prove to be too low. Better-than-expected corporate profits will likely drive further market gains. Our year-end S&P 500 price target is 4,400.

A key contributor to the earnings strength was once again mega-cap tech stocks with Facebook, Microsoft, Amazon, Apple and Alphabet all beating consensus expectations. The forces that have boosted these companies' profits during the pandemic remained in place in the first quarter, with particularly strong growth in key areas like online advertising and cloud services. That helps explain why growth-oriented stocks have recently outperformed more cyclically oriented stocks. The Russell 1000 Growth index is up 7% over the past month versus a 4% gain for the Russell 1000 Value index. The decline in real interest rates over this period likely prompted some rotation back into growth stocks. But the strong results from tech companies also helped. Ninety-five percent of tech stocks have so far beaten earnings forecasts—even better than top cyclical sectors, such as financials at 87% and energy at 58%.

Despite this tech strength, we see several reasons investors should prepare for a resumption of the rotation into cyclicals that took place earlier this year and consider rebalancing their portfolios after the rally in mega-cap tech stocks:

1. Catalysts for further mega-cap gains appear less obvious. More investor visibility on mega-cap share buyback plans may offer some near-term support, and companies are likely to use any share pullbacks as an opportunity to repurchase shares. However, we appear to be entering a less compelling quarter for mega-cap tech with limited product refreshes and upgrade cycles until the ramp-up into the year-end holiday season. More demanding year-over-year growth comparisons may also limit the scope for major earning beats into the second half.
2. The tactical outlook favors the reflation trade. Part of tech’s surprising resilience in the first quarter can be attributed to reopening setbacks, while a pause in the rise of US Treasury yields has lent support in recent weeks. But we don't expect either trend to extend further into the second quarter as vaccination progress, fiscal spending, and pentup demand give a fresh boost to cyclical sectors such as financials and energy. In addition, the earnings outlook for cyclical and value sectors appears more reliable on the back of recovering growth compared with  the high bar mega-cap tech firms will face as one-off pandemic drivers fade.
3. Growth and regulatory outlooks support a rotation within tech, too. As the growth outlook for mega-cap tech normalizes toward more incremental gains, we expect markets to seek out the strong long-run growth outlook offered by earlier-stage small- and mid-cap tech companies. A more combative US regulatory outlook may be another driver—a point underscored by the headwinds China mega-cap tech companies have faced from increased scrutiny. While regulatory impacts tend to be transitory, any short-term hit to dominant tech firms could lead to mid- and small-cap tech firms outperforming.

So while mega-cap tech companies have been a core part of the solid performance of portfolios throughout the pandemic, we think investors should be careful to avoid overallocation to this part of the market. In an environment of accelerating growth, we continue to prefer cyclical and value sectors such as financials and energy, while positioning for longterm structural growth in industries which could provide 'The Next Big Thing' (e.g., fintech, healthtech, and greentech).

Mark Haefele

UBS AG